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There were two big announcements in the crypto space this week and we anticipate that both will shape the dialogue in crypto circles over the course of the next few months.

NY AG Order re Bitfinex and Tether – the New York Attorney General announced an order requiring Bitfinex to provide certain information on its corporate activities to New York in connection with an investigation into Tether. The central issue is whether Bitfinex used Tether funds to “hide the apparent loss of $850 million dollars of [Bitfinex] co-mingled client and corporate funds.” The order was announced yesterday and sent the entire crypto market down 10%. Bitfinex has released a statement in response to the order saying that Bitfinex and Tether are “financially strong – full stop.” We anticipate this will be a major story over the next couple of weeks.

SeedInvest Receives ATS License – ever since the SEC released the DAO report in July 2017, firms have been trying to secure a broker-dealer with an Alternative Trading System. A broker-dealer with an ATS designation would allow a digital asset trading platform to legally provide an exchange/trading service in the US. SeedInvest (which was recently bought by Circle), through its affiliated broker-dealer SI Securities, just received the ATS designation (see here on page 11 – “The Firm operates an alternative trading system to facilitate the trading of securities previously purchased in private placement transactions through SI Securities.”). The ATS designation in this instance allows the firm to have a trading system/platform for previously issues equity securities (private placements) and not for tokens; however, it is generally viewed that this is the first step toward FINRA ultimately allowing for the ATS designation to apply to a token platform. We will see how this plays out with other platforms in the near future but this is certainly a sign that regulators are moving in the right direction.

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

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October 26, 2017

Clients, Friends, Associates:

This summer saw many exciting developments in the digital assets space as well as case law evolution that may expand the liability of fund managers. We would like to provide you with a brief overview of those topics and a few noteworthy items as we move into the fourth quarter of 2017.

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SEC Matters:

SEC Adopts Amendments to Form ADV and the Books and Records Rule. SEC amendments to Form ADV went into effect on October 1, 2017, which will apply to both registered investment advisers (“RIAs”) and exempt reporting advisers. Among other technical amendments, the new Form ADV requires investment advisers to provide detailed information with regard to their separately managed accounts (“SMAs”), including aggregate level reporting of asset types across an adviser’s SMAs and reporting of custodian information under certain circumstances. Investment advisers that utilize borrowing or derivatives on behalf of SMAs will also need to report the regulatory assets under management (“RAUM”) attributable to various levels of gross notional exposure and corresponding borrowings and derivatives exposure. The SEC noted that advisers may not need to report this SMA information until its annual amendment.

The SEC concurrently adopted an amendment to the books and records rule (Rule 204-2 under the Investment Advisers Act of 1940, as amended (“Advisers Act”)), requiring RIAs to keep records of documentation necessary to demonstrate the performance or rate of return calculation distributed to any person as well as all written performance-related communications received or sent by the RIA. Advisers who have questions on any changes to the new Form ADV should contact their compliance groups.

SEC Provides Observations from Cybersecurity Examinations. On August 7, 2017, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) published observations from its “Cybersecurity 2 Initiative” where 75 SEC registered broker-dealers (“BDs”), RIAs and investment funds were examined to assess cybersecurity preparedness. OCIE observed that all BDs and funds, and nearly all RIAs, maintained cybersecurity-related policies and procedures addressing protection of client information. OCIE also noted an increase in cybersecurity preparedness since the “Cybersecurity 1 Initiative” conducted in 2014.

However, key findings from the examinations include:

policies and procedures were inadequate and lacking specificity in employee guidance;

failure by financial firms to adhere to or enforce their policies and procedures; and

OCIE will continue its examination of financial firms’ cybersecurity compliance systems and we will be on the lookout for further guidance in this growing area of concern.

SEC Risk Alert Discusses Most Frequent Advertising Rule Compliance Issues. On September 14, 2017, OCIE published a risk alert based on its recent examination of 70 RIAs related to Rule 206(4)-1 under the Advisers Act (the “Advertising Rule”). The Advertising Rule generally prohibits RIAs from distributing advertisements or other communications that contain untrue, false or misleading statements. The most common Advertising Rule deficiencies observed include: (i) misleading performance results, caused by lack of sufficient disclosures, (ii) misleading one-on-one presentations, (iii) misleading claims of compliance with voluntary performance standards, (iv) cherry-picked profitable stock selections, (v) misleading selection of recommendations, and (vi) failure to implement compliance policies and procedures designed to prevent non-compliant advertising practices. OCIE encourages RIAs to consider their advertising activities within the purview of the Advertising Rule and its prohibitions.

SEC Action Against Hedge Fund Adviser. On August 21, 2017, the SEC reached a settlement with a hedge fund adviser for failing to establish, maintain, and enforce a compliance system to prevent the misuse of material, nonpublic information (“MNPI”). The settlement comes after the adviser’s analysts were charged with insider trading of MNPI relating to government plans to cut Medicare reimbursement rates. The SEC alleged that analysts received tips from a third-party political intelligence analyst who had a source within the Centers for Medicare and Medicaid Services, and that the adviser then used those tips to generate trading profits. The $4.6 million settlement included a penalty of $3.9 million and a disgorgement of compensation.

CFTC Matters:

CFTC Grants SEF and DCO Registration to LedgerX. The CFTC granted LedgerX registration status as both a swap execution facility (“SEF”) and a derivative clearing organization (“DCO”). Now that the exchange is live, LedgerX is the first CFTC-approved exchange to facilitate and clear options on digital assets. Previously, the CFTC granted SEF registration to TeraExchange, which offers forwards and swaps on Bitcoin. LedgerX plans to initially offer physically-settled and day-ahead swaps on Bitcoin to U.S.-based eligible contract participants (“ECPs”) and has a fully-collateralized clearing model where customers must post collateral to cover maximum potential losses prior to trading.

Digital Asset Matters:

CBOE Partners with Gemini to Launch Bitcoin Futures Exchange. On the heels of the CFTC’s LedgerX announcement, the Chicago Board Options Exchange (“CBOE”) announced that it has partnered with Gemini, a digital assets exchange and custodian, to launch the first U.S.-regulated Bitcoin futures exchange. Gemini was founded by the Winklevoss twins, whose proposed “Winklevoss Bitcoin Trust” ETF was rejected by the SEC this past spring. Gemini granted to CBOE an exclusive license to use Gemini’s Bitcoin market data that will allow CBOE to create derivative products, including indices, to trade on a CBOE-created exchange. Although CBOE has not requested approval from the CFTC to form such an exchange, it plans to offer Bitcoin futures by the end of 2017 or early 2018. We will keep managers apprised of ongoing developments.

House Introduces Virtual Currency Tax Act. In September, The Cryptocurrency Tax Fairness Act of 2017 was introduced in the House of Representatives. The bill was introduced by co-chairs of the Congressional Blockchain Caucus, Jared Polis (D-Co) and David Schweikert (R-Az), and calls for a de minimis exception from gross income for gains related to virtual currency transactions under $600. Such an exception could serve to incentivize small, day-to-day transactions. The bill also calls upon the Treasury Department to issue guidance on whether a gain or loss should be recognized in virtual currency transactions. If approved, the bill will apply to virtual currency transactions beginning January 1, 2018.

SEC Implicates Two ICOs in Alleged Fraud. On September 29, 2017, the SEC charged a businessman who was allegedly running two fraudulent initial coin offering (“ICO”) schemes by selling unregistered securities in the form of digital tokens that did not exist. The REcoin ICO was marketed as the first token backed by real estate investments and allegedly misrepresented to investors the company’s expertise and the amount of capital raised. The second ICO was marketed similarly but with respect to the diamond industry. In July, the SEC issued an investor alert warning about the risk of ICOs. The SEC is seeking to bar the businessman from participating in any offering of digital securities in the future.

ICOs Banned in China and South Korea. The People’s Bank of China (“PBoC”), China’s central bank and financial regulator, announced an immediate ban of ICOs within China. The announcement sent shockwaves throughout the cryptocurrency industry, highlighted by declines across various token prices. Many see this ban as a temporary stop-gap measure to give PBoC time to develop industry oversight. South Korea’s Financial Services Commission made a similar announcement a few weeks later, stating that all ICO fundraising would be banned and that it would establish tighter anti-money laundering prevention policies for virtual currencies.

Other Items:

Department of Labor (“DOL”) Proposes Amendments to Fiduciary Rule Exemptions. The DOL Fiduciary Rule, discussed in our previous quarterly update, may face further delays before full implementation. Citing a concern that affected parties may incur undue expense in complying with a rule that may be further revised or repealed, the DOL submitted a proposal to the Office of Management and Budget (“OMB”) to extend the transition period from January 1, 2018 to July 1, 2019. The proposal included amendments to a few of the Fiduciary Rule exemptions, including the best interest contract exemption, which permits investment advisers to retail retirement clients to continue their current fee practices. The OMB approved the proposal and the DOL published its proposal on August 31, 2017. Proponents for the amendments point to the SEC’s commitment to work with the DOL to harmonize the Fiduciary Rule with SEC regulations, and that the delay will give the agencies time to develop clear regulations together. Critics claim that the delay will cause more uncertainty in the market during the extended transition period, and that the delay is the first step in an attempt by opponents of the rule to eliminate it completely.

The Cayman Islands Introduce New AML Regulations. New Cayman Islands AML regulations came into effect on October 2, 2017. The new regulations expand AML/CFT (anti-money laundering/countering the financing of terrorism) obligations to unregulated investment entities and additional financial vehicles, which are seen to align more closely with the Financial Action Task Force (FATF) recommendations and global practice. In a shift to a risk-based approach to AML regulations, there will be two separate due diligence procedures depending on the risk assessment of investors. Certain investors that are deemed to be high-risk, such as politically exposed persons, will have to go through a more extensive verification process, while low-risk investors will be able to submit to a simplified due diligence process. If you have any questions, we recommend that you reach out to your administrator or offshore counsel.

U.S. Court of Appeals for the Second Circuit Clarifies Insider Trading Case. In August 2017, in a long-awaited opinion, the Second Circuit upheld a former portfolio manager’s 2014 conviction for insider trading in U.S. v. Martoma, in reaction to the US Supreme Court’s intervening ruling in Salman v. United States, which we discussed in a previous update. The Martoma Court rejected much of its earlier decision in U.S v. Newmanby holding its previous requirement that there be a “meaningfully close personal relationship” between tipper and tippee was “no longer good law”. Instead, the Martoma Court created a new standard requiring the government to prove that the tipper expected the tippee to trade on the information and the tip “resembled trading by the insider followed by a gift of the profits”. By eliminating Newman’s “close personal relationship” requirement, the Martoma ruling has made it easier for the government to prosecute and win insider trading cases, however, it’s likely this area of law will continue to evolve.

“Group” Theory of Liability Expanded by U.S. District Court. Continuing a trend of expanding the “group” theory of liability, the Northern District of California’s recent ruling in Sand v. Biotechnology Value Fund, L.P.may have far-reaching ramifications for managers of multiple funds. The defendants in the ongoing Sand case include a general partner and its two hedge funds (the “group funds”). The Court held that the group funds’ aggregate collective ownership of the subject security was directly relevant to the issue of beneficial ownership because the group funds shared the same general partner. Section 16 of the Securities and Exchange Act of 1934, as amended, requires corporate insiders and beneficial owners of 10% or more of a registered security to file statements with the SEC disclosing their ownership interest. Under the Sand Court’s theory of group liability, each of the group funds would be subject to the Section 16 reporting requirements if the group collectively owned 10% or more of the security, even if an individual group fund owned less than 10%, and each group fund could also be directly liable for any Section 16 violations. Given this evolution of Section 16 liability, managers of multiple funds that hold positions in the same security should carefully monitor beneficial ownership and evaluate whether a reporting obligation may exist for their funds.

SIPC and FINRA Adopt Streamlined Reporting Process. Effective September 1, 2017, investment advisory firms who are members of both the Securities Investor Protection Corporation (“SIPC”) and the Financial Industry Regulatory Authority (“FINRA”) only need to file one annual report to both agencies through FINRA’s reporting portal. This will ease the reporting burden, as well as cut down on compliance costs for firms.

FCA Makes Final Policy Statement on MiFID II. The Financial Conduct Authority (“FCA”), which regulates the financial services industry in the UK, has published its final policy statement regarding the Markets in Financial Instruments Directive II (“MiFID II”). Effective January 1, 2018, MiFID II most notably introduces the requirement for UK BDs to “unbundle” investment research from trading commissions, requiring discrete pricing for each of the services rendered. This requirement is in contrast to the “soft dollar” safe harbor currently available in the U.S. and may have implications for U.S.-based investment advisers who engage UK BDs, as the new requirement could affect pricing of services.

Cayman and BVI Update Beneficial Ownership Regimes. Amendments to the Cayman Islands beneficial ownership laws went into effect on July 1, 2017, which require certain entities, including exempted funds, to take reasonable steps to identify their beneficial owners (generally persons holding more than 25% interests in an entity). Of interest to fund managers, the amendments exempt from its scope: funds that are regulated by Cayman Islands Monetary Authority (“CIMA”), that employ a Cayman regulated administrator, or funds that are managed by an adviser regulated in an approved jurisdiction, such as a state or SEC RIA. The British Virgin Islands (the “BVI”) also implemented amendments to its beneficial ownership regime effective July 1, 2017, which now requires registered agents of non-exempt BVI companies, such as unregulated private funds, to input beneficial ownership information into a platform called the BOSS (Beneficial Ownership Secure Search) System. The BOSS System is accessible only to select regulators and fulfills BVI commitments to the United Kingdom under the UK Exchange of Notes agreement.

MSRB to Hold Compliance Outreach Program. In a cross-agency announcement, the SEC is partnering with the Municipal Securities Rulemaking Board (“MSRB”) and FINRA to sponsor the 2017 Compliance Outreach Program for Municipal Advisors, a day-long compliance forum to allow industry professionals to discuss compliance practices with regulators and to promote a more effective compliance structure for municipal advisors. The program will be held on November 8, 2017, from 9am to 4pm ET, in the SEC’s Atlanta Regional Office and will be streamed live on the SEC website. The agenda for this event can be located here, and any advisors who are interested in attending can register here.

Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

Deadline – Filing

October 1, 2017 – Revised Form ADV 1A goes into effect for all advisers

October 16, 2017 – Quarterly Form PF due for large liquidity fund advisers (if applicable).

November 14, 2017 – Form PR filings for registered Commodity Trading Advisors (“CTAs”) that must file for Q3 within 45 days of the end of Q3 2017.

November 29, 2017 – Form PF filings for Large Hedge Fund Advisers with December 31 fiscal year-ends filing for Q3 2017.

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us.

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August 23, 2017

Clients, Friends, Associates:

We hope you are enjoying the summer. Although the second quarter is typically not as busy as the first quarter from a regulatory/compliance standpoint, we saw many regulatory developments this quarter, as well as a surge in digital asset investment activity. Below is an overview of noteworthy items, as well as what to expect as we move into the third quarter.

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SEC Matters:

Proposed SEC Amendment to Advisers Act for VC and Private Fund Advisors. On May 3, 2017, the SEC proposed a rule to amend the Investment Advisers Act of 1940, as amended (the “Investment Advisers Act”), that would amend the definition of a “venture capital fund” and the definition of “assets under management” with respect to the private fund adviser exemption. For purposes of the exemption for advisers to venture capital funds, small business investment companies (“SBIC”) would be included in the definition of a venture capital fund. This would expand exemption coverage for advisers solely relying on the SBIC adviser’s exemption. Eligible advisers would file as an “exempt reporting adviser,” reducing the extra costs and burdens of recordkeeping required of registered investment advisers. Additionally, with respect to the private fund adviser exemption, currently firms that advise solely private funds and that have less than $150 million of regulatory assets under management are exempt from registration with the SEC. The proposed rule would exclude SBIC assets from the calculation of private fund assets used to determine if the $150 million threshold has been crossed. The SEC closed requests for comment on the proposal on June 8, 2017.

SEC Seeks Input Regarding Department of Labor (“DOL”) Fiduciary Rule. SEC Chairman Jay Clayton issued a statement on June 1, 2017 welcoming public input to help the SEC formulate its assessment of the impact the DOL’s Fiduciary Rule (as discussed further below) may have on investors and entities regulated by the SEC. The statement was released in anticipation of a DOL request for information from the SEC to promote consistency and clarity with respect to implementation of the rule between the two agencies. Interested individuals can respond to SEC questions about the rule’s impact on investment advisers and broker-dealers via email or an online webform. Public submissions remain open and are currently available for review.

SEC Action Against Outsourced CCO. On August 15, 2017, the SEC reached a settlement with an outsourced CCO and his consulting firm, which offered compliance consulting and outsourced CCO services to investment advisory firms. The outsourced CCO served as CCO for two registered investment advisers (collectively, “Registrants”). The SEC found the Registrants either filed their Form ADV annual amendments late or not at all, and the outsourced CCO relied on estimates provided by the Registrants’ CIO. It was established the AUM and number of advisory accounts reported on the Form ADV were greatly overstated, and the outsourced COO did not confirm the accuracy of the information. The SEC held the outsourced CCO violated the Investment Advisers Act by failing to amend the Form ADV annually and willfully submitting a false statement. The SEC suspended the outsourced CCO from association or affiliation with any investment advisers for one year and ordered him to pay a $30,000 civil penalty. The action indicates that outsourced compliance persons solely relying on internal estimates of AUM and number of advisory contracts, without further confirmation, are at risk of filing false reports and subject to enforcement with the SEC.

CFTC Matters:

CFTC Requests Input to Simplify and Modernize Commission Rules. In response to President Trump’s executive order to reform regulations to stimulate economic growth, the CFTC is requesting public input in an effort to simplify and modernize CFTC rules and make complex CFTC regulations more understandable for the public. Rather than rewrite or repeal existing rules, a primary goal of Project Keep it Simple Stupid (“Project KISS“) is to find simpler means of implementing existing rules. The CFTC will review rules with an ultimate goal of reducing regulatory burdens and costs for industry participants. The solicitation period for comments began on May 3, 2017 and will close on September 30, 2017. Comments can be submitted via the Project KISS portal on the CFTC’s website.

CFTC Approves Amendments to Strengthen Anti-Retaliation Whistleblower Protections. The CFTC unanimously approved new amendments to the “Whistleblower Incentives and Protection” section of the Commodity Exchange Act of 1936, as amended (the “CEA”) on May 22, 2017. The amendments provide for greater anti-retaliation measures against employers who attempt to retaliate against employees that report employer CEA violations. Further, the amendments help clarify the process of determining whistleblower awards. The amendments will become effective July 31, 2017.

CFTC Unanimously Approves Recordkeeping Amendment Requirements. On May 23, 2017, the CFTC unanimously approved amendments to Regulation 1.31 to clarify the rule and modernize the manner and form required for recordkeeping. Specifically, the amendment will allow the manner and form of recordkeeping to be technology-neutral (i.e. not requiring or endorsing any specific record retention system or technology, and not limiting retention to any format). The amendments do not expand or decrease any existing requirements pertaining to regulatory records covered by other CFTC regulations.

Digital Asset Matters:

CoinAlts Fund Symposium. Cole-Frieman & Mallon LLP is pleased to announce that it is hosting, along with fellow symposium sponsors Arthur Bell CPAs, MG Stover & Co., and Harneys Westwood & Riegels, the CoinAlts Fund Symposium on Thursday, September 14, 2017, in San Francisco. This one-day symposium is for managers, investors and service providers in the cryptocurrency space and discussion points will include cryptocurrency investment, as well as legal and operational issues pertaining to this new asset class. The key-note speaker will be Olaf Carlson-Wee, Founder and CEO of Polychain Capital, and the symposium will include a number of other speakers representing the perspectives of investment management, fund administration, audit and tax, custody of funds, offshore fund formation and compliance. Early bird registration for investors, manager and students ends August 31st.

California Proposes a BitLicense via the Virtual Currency Act. Following in New York’s footsteps with its implementation of a BitLicense to regulate virtual currency activity in New York, California has proposed A.B. 1123 (or the “Virtual Currency Act”), its own version of a BitLicense. If passed, any persons involved in a “virtual currency business” must register with the California Commissioner of Business Oversight (the “Commissioner”). Under the Virtual Currency Act, a “virtual currency business” is defined as maintaining full custody or control of virtual currency in California on behalf of others. The application and registration process includes an extensive review of the business by the Commissioner, maintenance of a minimum capital amount, annual auditing, and an application fee of $5,000 with a $2,500 renewal. Currently aimed at those offering exchanges or wallet services we do not believe digital asset fund managers will need to obtain this licence. More information can be found here.

SEC Grants Review of Initial Rejection of Winklevoss Bitcoin Exchange-Traded Fund. In March, the SEC rejected a proposed rule change to list and trade shares of the Winklevoss Bitcoin Trust as commodity-based trust shares on the Bats BZX Exchange. In the disapproval order, the SEC claimed that the bitcoin market was too unregulated at the time, and the BZX Exchange would therefore lack the capability of entering into necessary surveillance-sharing agreements that are required of current commodity-trust exchange traded products. Bats BZX Exchange filed a petition for review of the disapproval order. The SEC granted the petition in April and has yet to release any further comments. As digital asset trading has increased over the past few months, many are looking at the review of the petition as a potential indicator of future cryptocurrency regulation to come.

SEC Petitioned for Proposed Rules and Regulation of Digital Assets and Blockchain Technology. A broker-dealer operating an alternative trading system (“ATS”) for unregistered securities, petitioned the SEC for rulemaking regarding guidance on digital assets. The Petitioner argued that some digital assets should be considered securities, and that current regimes in the United Kingdom and Singapore can be modeled domestically to successfully facilitate the issuance and trading of digital assets. The model currently used by those countries is known as a “regulatory sandbox,” in which companies are allowed to operate without significant regulatory interference, so long as they do so within a set of established rules. As of today, the SEC has not responded to the petition, but we expect the frequency of petitions and requests for no-action letters to increase as this space continues to grow.

Other Items:

Department of Labor (“DOL”) ‘Implements’ Fiduciary Rule. On June 9, 2017, the DOL partially implemented its amended fiduciary rule (the “Fiduciary Rule”), which expands the definition of a “fiduciary” subject to important exemptions. On August 9, 2017 the DOL submitted proposed amendments to these exemptions thereby delaying enforcement; and extending the transition period and uncertainty over the ultimate fate of the fiduciary rule by another eighteen months to July 1, 2019. Managers with questions regarding the applicability of these exemptions should discuss with counsel.

Generally, anyone that makes a “recommendation” as to the value, disposition or management of securities or other investment property for a fee or other compensation, to an employee benefit plan or a tax-favored retirement savings account such as an individual retirement account (“IRA”) (collectively “covered account”) will be deemed to be providing investment advice and, thus, a “fiduciary,” unless an exception applies. Many fund managers and other investment advisers may unintentionally be deemed to be fiduciaries to their retirement investors under the amended rule. Fund managers with investments from covered accounts or that wish to accept contributions from covered accounts will need to consider whether their current business activities and communications with investors could constitute a recommendation, including a suggestion that such investors invest in the fund. Under certain circumstances, fund managers may be deemed fiduciaries. Notably, the Fiduciary Rule provides an exception for activity that would otherwise violate prohibited transaction rules which is applicable to investments made by plan investors who are represented by a qualified independent fiduciary acting on the investor’s behalf in an arms’ length transaction (typically for larger plans). For clients or investors that do not have an independent fiduciary, managers must evaluate whether they are fiduciaries and what actions must be taken to comply with ERISA’s fiduciary standards or the prohibited transaction rules. The Fiduciary Rule also contemplates a Best Interest Contract (“BIC”) Exemption, which permits investment advisers to retail retirement investors to continue their current fee practices, including receiving variable compensation, without violating prohibited transactions rules, subject to certain safeguards.

We recommend that investment advisers contact their counsel regarding making any necessary updates to the applicable documents.

MSRB Establishes Continuing Education Requirements for Municipal Advisors. Beginning January 1, 2018, the Municipal Securities Rulemaking Board (“MSRB”) will implement amendments requiring municipal advisors to have a continuing education program in place for “covered persons” and require such persons to participate in continuing education training. The amendment will require an annual analysis to evaluate training needs, develop a written training plan, and implement training in response to the needs evaluated. The amendments also provide for record-keeping of the plans and analysis to promote compliance. Municipal advisors will have until December 31, 2018 to comply with the new requirements. To further clarify the requirements, the MSRB will be hosting an education webinar for municipal advisors on Thursday October 12, 2017, from 3:00 p.m. to 4:00 p.m. EDT.

Full Implementation of MSRB Series 50 Examination. The grace period for municipal advisor representatives and municipal advisor principals that have not passed the Series 50 examination to qualify as a municipal advisor representative or principal will be ending on September 12, 2017. Thereafter, all municipal advisor professionals who either engage in municipal advisory activities or engage in the management or supervision of municipal advisory activities will be required to pass the Series 50. The MSRB has a content outline which specifies eligibility, the structure of the exam, and the regulations to be tested.

Form ADV Technical Amendment Including Wyoming for Mid-Size Advisers. On July 1, 2017, a technical amendment to Form ADV was implemented to reflect a new Wyoming law that now requires investment advisers with $25 million to $100 million in AUM and a principal place of business in Wyoming to register with the state as an investment adviser instead of the SEC. The technical amendment will also appear on Form ADV-W.

Further Updated CRS Guidance Notes. The Cayman Islands Department for International Tax Cooperation (“DITC”) and the Cayman Islands Tax Information Authority (“TIA”) issued further guidance notes on April 13, 2017 for compliance with Automatic Exchange of Information (“AEOI”) obligations. Among some of the more important notes are the following:

US FATCA notification and reporting deadlines will now parallel the Common Reporting Standard (“CRS”) deadlines. The notification deadline was June 30, 2017, and the reporting deadline will be July 31, 2017.

The deadline for correcting any FATCA report errors for 2014 and for 2015 will be July 31, 2017.

CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the AEOI portal.

Certain Digital Assets are Securities Based on “Facts and Circumstances”

As has been widely anticipated by the cryptocurrency community, the SEC has finally made an initial declaration of the agency’s view that certain digital assets are securities subject to jurisdiction and regulation by the SEC. In a series of four items (press release, investigative report, statement and investor bulletin), the SEC comes out with a strong warning to sponsors of Initial Coin Offerings (ICOs) to be careful of the U.S. securities laws. While many will undoubtedly think the SEC missed a great opportunity to provide robust guidance (and leniency) to the industry, most market participants recognize that this series of discussions was the most likely outcome for many of these instruments (i.e. it is clear that they are securities). Although it is not perhaps what the industry wanted, we at least have *something* to now go by and the industry can begin to figure out how it will structure itself from here.

Below we provide an overview of the various parts of the release as well as some of our observations.

SEC Four Items

The SEC released the following four items today which we describe in greater depth below:

Press Release – the release discusses the investigative report it published on The DAO and discusses the investor bulletin created regarding ICOs. The SEC cautions market participants to make sure they examine their activity with respect to ICOs and other structures built on blockchain and distributed ledger technology. Most importantly the release states:

In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology

SEC Report on the DAO – the report describes the rise and fall of The DAO, discusses how the related facts would be analyzed under the existing securities laws (Howey test), determines that DAO Tokens are securities, and makes the determination that certain “Platforms” are securities exchanges that should be (and should have been) registered with the SEC as securities exchanges. The report ends by listing a number of SEC enforcement actions involving virtual currencies. The SEC also provides the following warning to the industry:

Whether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction. Those who offer and sell securities in the United States must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws…These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology. In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration.

CorpFin/Enforcement Statement – the statement basically provides an overview of the U.S. securities regulatory framework and describes how the framework of laws and regulations are designed to protect investors. It discusses the importance of “facts and circumstances” analysis, states that DAO Tokens are securities based on “facts and circumstances” and implores cryptocurrency market participants to seek counsel from private attorneys or the SEC. The statement also warns of bad actors and red flags.

Investor Bulletin – provides background on ICOs, discussed various concepts applicable to the digital asset industry (blockchain, virtual currency, virtual currency exchanges, smart contracts), and discusses the crowdfunding regulations. The bulletin also alerts investors to the issues with getting money back in the event of a scam (tracing issues, international scope of digital assets, the fact there is no central regulator and there is no ability for the SEC to freeze digital assets) and describes the normal things to be careful of that are common in many scams.

Observations

The following are some quotes from the various items produced by the SEC which we found interesting, and our thoughts on those quotes.

Press Release

“Those participating in unregistered offerings also may be liable for violations of the securities laws.”

HFLB: we note that the SEC is intentionally being vague when it references “those participating” – this indicates they will be looking at all parties related to a particular transaction, from sponsors to exchanges to other persons within the ICO distribution chain.

“Additionally, securities exchanges providing for trading in these securities must register unless they are exempt.”

HFLB: here they are basically saying any exchange that DAO Tokens were available on were acting as securities exchanges and needed to be appropriately registered as such.

“The DAO has been described as a “crowdfunding contract” but it would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority.”

HFLB: we find it interesting that the SEC is specifically talking about the crowdfunding regulations. We think that many ICOs / token sales would be good candidates for these platforms (and some tokens have started in that way) and the SEC seems to be highlighting an option for certain fund sponsors. Crowdfunding platforms are regulated by the SEC and FINRA (and do not have as onerous requirements as normal securities registration statements) so they may become an acceptable compromise distribution platform for both ICO sponsors and the SEC.

Report on The DAO

“The United States Securities and Exchange Commission’s (“Commission”) Division of Enforcement (“Division”) has investigated whether The DAO, an unincorporated organization; Slock.it UG (“Slock.it”), a German corporation; Slock.it’s co-founders; and intermediaries may have violated the federal securities laws.”

HFLB: the “sponsors” of The DAO were investigated, which is to be expected. We find it interesting they used the word “intermediaries” which is probably intentionally vague.

“The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws. This Report also serves to stress the obligation to comply with the registration provisions of the federal securities laws with respect to products and platforms involving emerging technologies and new investor interfaces.” (citations omitted)

HFLB: pretty much what securities lawyers have been saying all along.

“From April 30, 2016 through May 28, 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for a total of approximately 12 million Ether (“ETH”), a virtual currency used on the Ethereum Blockchain.” (citations omitted)

HFLB: we believe that the SEC is saying here that Ether is not a security, but is instead a virtual currency. This is important because it shows that some ICOs or digital assets (like ETH) can be instruments other than securities.

“The Commission is aware that virtual organizations and associated individuals and entities increasingly are using distributed ledger technology to offer and sell instruments such as DAO Tokens to raise capital. These offers and sales have been referred to, among other things, as “Initial Coin Offerings” or “Token Sales.” Accordingly, the Commission deems it appropriate and in the public interest to issue this Report in order to stress that the U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.”

HFLB: unfortunately looking to the “facts and circumstances” is all we have here – the SEC is not going to come out with a list of tokens they think our securities so we have to use the “sniff test” to determine whether any particular token is a security. The best advice we have here is to look at the Coinbase Securities Law Framework to come up a best guess.

“The Platforms that traded DAO Tokens appear to have satisfied the criteria of Rule 3b-16(a) and do not appear to have been excluded from Rule 3b-16(b). As described above, the Platforms provided users with an electronic system that matched orders from multiple parties to buy and sell DAO Tokens for execution based on non-discretionary methods.”

HFLB: the SEC is putting those website where DAO Tokens were bought/sold on notice that they were operating as a securities exchange. This will likely give unregistered crypto exchanges pause with respect to many digital asset instruments.

CorpFin / Enforcement Statement

“Market participants in this area must also consider other aspects of the securities laws, such as whether a platform facilitating transactions in its securities is operating as an exchange, whether the entity offering and selling the security could be an investment company, and whether anyone providing advice about an investment in the security could be an investment adviser.”

HFLB: the SEC makes reference to the mutual fund regulations (also applicable to private funds via 3(c)(1) and 3(c)(7) exemptions) as well as the investment advisor regulations, which are applicable to cryptocurrency fund managers.

“Although some of the detailed aspects of the federal securities laws and regulations embody more traditional forms of offerings or corporate organizations, these laws have a principles-based framework that can readily adapt to new types of technologies for creating and distributing securities.”

HFLB: this is exactly why we were surprised that the SEC has not previously issued guidance when it was clear there were other groups who have conducted ICO sales that clearly were securities offerings. The SEC has had the opportunity (and, really, the obligation) to be enforcing the current securities laws in this space and the SEC has specifically chosen not to.

“Finally, we recognize that new technologies also present new opportunities for bad actors to engage in fraudulent schemes, including old schemes under new names and using new terminology. We urge the investing public to be mindful of traditional “red flags” when making any investment decision, including: deals that sound too good to be true; promises of high returns with little or no risk; high-pressure sales tactics; and working with unregistered or unlicensed sellers.”

HFLB: we agree. We fully expect to a number of frauds and other enforcement actions taken with respect to ICOs in the future.

Investor Bulletin

“Although ICOs are sometimes described as crowdfunding contracts, it is possible that they are not being offered and sold in compliance with the requirements of Regulation Crowdfunding or with the federal securities laws generally.”

HFLB: we believe that these various releases will ultimately push more ICOs to look toward crowdfunding platforms for their initial offerings. We also believe that there is the possibility in the future for some sort of digital asset specific crowdfunding platform or a digital asset broker-dealer.

“Ask what your money will be used for and what rights the virtual coin or token provides to you. The promoter should have a clear business plan that you can read and that you understand. The rights the token or coin entitles you to should be clearly laid out, often in a white paper or development roadmap. You should specifically ask about how and when you can get your money back in the event you wish to do so. For example, do you have a right to give the token or coin back to the company or to receive a refund? Or can you resell the coin or token? Are there any limitations on your ability to resell the coin or token?”

HFLB: we believe this guidance is not really helpful for many ICO structures.

“Fraudsters often use innovations and new technologies to perpetrate fraudulent investment schemes. Fraudsters may entice investors by touting an ICO investment “opportunity” as a way to get into this cutting-edge space, promising or guaranteeing high investment returns. Investors should always be suspicious of jargon-laden pitches, hard sells, and promises of outsized returns. Also, it is relatively easy for anyone to use blockchain technology to create an ICO that looks impressive, even though it might actually be a scam.”

HFLB: we agree. We believe it is highly likely there will be a number of scams that will be perpetuated through ICOs.

Conclusion

This is a first step of sorts toward more robust regulation of the digital assets. Although we get some insight from the SEC, we don’t really see anything new and we don’t see how the SEC is going to protect the digital asset markets in the U.S. Instead, this probably plays into fears that the U.S. is not a hospitable jurisdiction to novel ideas and structures and will ultimately push ICOs that would be based in the U.S. to offshore jurisdictions. We hope the SEC uses these statements as a springboard to a dialogue with the industry to keep (and attract) innovators to the U.S. More obviously forthcoming…

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

As we discussed in a recent post, New York has already implemented a statute that requires those engaged in certain virtual currency business activities to obtain a license from the state. In a similar fashion, California has proposed A.B. 1123 (the “Bill” or “Virtual Currency Act”) that would allow the state to begin regulating the industry. This post focuses on California’s proposed version of a “BitLicense”, which like New York, would prohibit a person from engaging in a virtual currency business activity unless they receive a license from California’s Commissioner of Business Oversight (“Commissioner”).

California Virtual Currency Act – A.B. 1123

Pursuant to the Virtual Currency Act, any persons involved in a “virtual currency business” in California must register with the Commissioner. The Act defines a “virtual currency business” as “maintaining full custody or control of virtual currency in this state on behalf of others.” The definition of “virtual currency” is very broad (“any type of digital unit that is used as a medium of exchange or a form of digitally stored value”) although there are some carveouts for gaming platforms and for consumer reward programs.

The above definition seems to capture those groups who are offering exchange and wallet services for persons who are buying, selling and holding bitcoin and other digital currencies. Right now we don’t believe that a cryptocurrency hedge fund entity or its manager/general partner would need to obtain the license – a fund would simply be holding virtual currency on behalf of itself and therefore the general partner entity would not need to be registered.

California Application Process

In the event an entity needs to register, there is an application process where the Commissioner will engage in an extensive review of the applicant’s background and services offered. California would also require an initial $5,000 application fee, a renewal fee of $2,500, and the maintenance of a minimum amount of capital as determined by the Commissioner. The licensee would be required to have an annual audit and would need to provide balance sheets, income statements, and other financial verification forms on a periodic basis. A provisional license may be granted for a $500 fee to those engaged in a virtual currency business with less than $1,000,000 in outstanding obligations, and if the business model represents a low or no risk to consumers (as determined by the Commissioner). The provisional licensee may also be required to register as a money services business.

Looking Forward

As the definition of a virtual currency business is very broad, this Bill (like a predecessor bill which was abandoned) is heavily opposed by digital non-profit organizations, as well as many others in the space. It is yet to be seen whether this Bill will be passed or amended once again. However, the Bill’s reintroduction does demonstrate that lawmakers are still eager to regulate the industry. If passed, the Virtual Currency Act would become effective July 1, 2018. We will continue to follow the developments surrounding California’s Virtual Currency Act, and any potential impact this may have on investment managers in the state.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

After a number of recent, high-profile and wildly successful Initial Coin Offerings or “ICOs”, the blockchain-based asset industry has been abuzz about new ICOs as well as the regulatory issues that surround the space. This post provides a quick overview of the big securities laws issues surrounding these assets and discusses the regulatory structure currently applicable to the space.

Initial Background

An initial coin offering is the first distribution of a digital currency or digital token, normally offered exclusively through an online offering. These coins or tokens, like many existing cryptocurrencies such as Bitcoin or Ether, may represent some sort of fractional ownership in something (working similar to a security) or may represent a form of payment (like a currency). These tokens may be pre-launch (to raise money to develop the use case, similar to crowd-funding) or post-launch (use case already exists).

Are ICOs Securities?

The first and biggest question related to ICOs is whether they are securities offerings (essentially digitized IPOs). For any inquiry into whether something is a security or not, the starting point is the Howey Test. Howey is a basic four-part test that is used to determine whether a contract, a transaction, or a series of actions constitutes a security under the Securities Act of 1933. The very broad overview of the Howey prongs are:

It is an investment of money

There is an expectation of profits from the investment

The investment of money is in a common enterprise

Any profit comes from the efforts of a promoter or third party

For many ICOs the answers to all of the above are usually “yes”. We do, however, believe that some ICOs are not securities under the test and, although we start with Howey, that is not where the analysis stops. As mentioned before in our post dealing with Bitcoin Hedge Funds, we believe that Debevoise’s Securities Law Framework provides a thoughtful approach to think about and analyze this question. We also believe that the SEC will clarify its position regarding ICOs in the next several months.

Use Case – Blockchain Capital

One of the more interesting ICOs recently has been the ICO for the Blockchain Capital Token (BCAP Token, on TokenHub), which was placed by Argon Group, a blockchain asset investment bank. Here the value of the BCAP Token is linked to the value of a newly created venture capital fund (which initial assets were received through the BCAP Token ICO process). The subscription process of the ICO was conducted through a Regulation D 506(a) offering (see Blockchain Capital Token Form D), so there are a number of regulations that the group has already gone through, although none specifically dealing with the ICO itself. What is particularly amazing is that the offering of $10M was oversubscribed and closed in only 6 hours. The power of the ICO is apparent – what investment fund manager would not want to raise money in a very quick and efficient manner?

Blockchain Capital paved the way for ICOs linked to private investment funds – we would expect to see tokens linked to hedge funds and private equity funds in the near future. While the Blockchain Capital offering was limited to accredited investors, the offering still presents questions about regulations, including the potential for fraud. We liken the ICO process to something akin to the crowdfunding process and believe there are similar risks, in addition to the normal risks associated with the linked asset (in this case, a VC fund).

Future Regulation?

There is no doubt that the regulators will begin to figure out a regulatory regime for ICOs and cryptocurrencies, and this is likely to happen before any sort of Congressional action to change the laws of any of the securities or commodities acts. The CFTC has already been active in the space (see our previous notes in our Client Update here) and it is very likely that the SEC will be starting the process to issue regulations as well (see here where a group has petitioned the SEC to begin that process). We believe that during that comment and rulemaking process, the regulators will need to address a number of items, including the process with respect to ICOs. The SEC needs to move with a deft hand, however, because any onerous regulations will just push business offshore – there are already exchanges who discriminate against potential market participants based on domicile (either with respect to U.S. domicile, or in some cases, New York domicile for fear of issues around the New York BitLicense regulations).

The crowdfunding space became regulated fairly quickly and there are now specific crowdfunding broker-dealers and I believe the same will be the case with the ICO regime. We believe that any cryptocurrency regulatory regime will include requirements with respect to ICOs and ICO investment banks.

Conclusion

The ICO market is white hot and getting hotter. It will undoubtedly create both winners and losers (and the winners are likely to be massive winners) and in some cases will usher in new ideas and technologies that will help define the landscape of Web 3.0. The most important thing for regulators (and lawmakers) is to make sure all investors in these offerings are protected and provided with all necessary information and opportunities as provided through the current securities and commodities laws. We believe that such regulation will come sooner rather than later.

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

[Note: information posted on May 19, 2017. Certain areas below will be updated periodically and we will update the timing of the information in each particular section.]

We recently wrote an overview of bitcoin/altcoin hedge funds. That post led to a number of conversations with current and future cryptocurrency managers which yielded a number of questions regarding the business and regulatory issues applicable to these fund structures. Some of the items we discussed are issues of first impression. Some of the items probably don’t have “for sure” answers and instead we look to industry best practices for guidance. While there will be a lot of “grey areas” and “probablys” and “I don’t knows” in this space as the regulators start to become more involved, I have tried my best to address these items below in my answers to these common questions.

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Are Bitcoins and other Cryptocurrencies “securities” under the Securities Act of 1933?

Many of the very large cryptocurrencies like Bitcoin and Ethereum are probably not “securities”, and can probably be classified as “digital currencies” for now. Other cryptocurrencies or tokens would need to be examined on a facts and circumstances basis. For such an inquiry, I believe the Coinbase Securities Law Framework (See Appendix A) is a great place to start.

Why does it matter?

If a hedge fund invests in or buys a cryptocurrency, and that cryptocurrency is deemed to be a security, then the fund’s management company (general partner) will be, by definition, an investment adviser under federal law and most likely the laws of the state where the management company operates (where the sponsor/owner of the management company is physically located). If the management company is an investment adviser, then the management company will need to register with the SEC (upon reaching certain asset levels, generally $150M) or with a state securities commission. Some states may have exemptions from registration, like the Exempt Reporting Adviser (ERA) regime. (See here for information on the SEC ERA regime and here for California’s ERA regime.) If a management company registers as an investment adviser or ERA, the manager will be required to have the fund undergo an annual audit, and there will also be a requirement that performance fees be charged only to qualified clients. Additionally, regardless of manager’s registration status (SEC, state or is an ERA) the manager will be subject to the anti-fraud provisions of Section 206-4 of the Investment Advisers Act which generally governs the manner in which the adviser communicates with the public.

If a cryptocurrency is deemed to be a security, then the fund would also technically be subject to the Investment Company Act of 1940. Most hedge funds utilize either the 3(c)(1) or 3(c)(7) exemption from registration under the ICA. In general this will not wildly change the fund’s offering documents, but it will be an item that needs to be addressed.

What if the cryptocurrencies are not deemed to be securities?

If the fund only invests in assets that are not securities, then the investment advisory regulatory regime does not apply. This means there would be no regulatory requirement for an audit (assuming no CFTC regulations apply) and the manager could charge performance fees to non-qualified clients. The Investment Company Act would also not apply which means that the fund would be able to have more than 99 investors. The fund would, however, still be limited to 35 non-accredited investors over the life of the fund to maintain the 506 exemption under the Securities Act.

What about state regulations and New York’s BitLicense registration requirement?

Outside of the investment advisory regulations that would be applicable to a manager if the cryptocurrency or token was deemed to be a security, the states don’t really have regulations applicable to bitcoin managers.

With respect to New York’s BitLicense requirement, we believe that currently these regulations are not applicable to the standard bitcoin hedge fund manager who is only buying and selling bitcoin (and other tokens/altcoins) for the fund’s account. The BitLicense requirements may apply (depending on facts and circumstances) to managers who engage in other aspects of the cryptocurrency industry – such as issuing coins or otherwise acting as an exchange platform. We expect other states to develop legal and regulatory frameworks similar to New York in the future, and in the event the SEC attempts to shoehorn bitcoin managers into the definition of investment adviser, we believe the states would shortly follow suit.

What about an auditor? If I have to have an audit, what will that be like and how much will it cost?

In the event a manager engages an auditor, the auditor will be able to discuss the process and procedures that will be employed. Because there is additional work involved in a bitcoin launch, it is likely that an audit will be more expensive than for a similarly sized fund investing only in publicly traded securities.

There are not many groups who can audit funds in this space. Some groups can audit in this space, but can only audit major cryptocurrencies. As more groups get into the space and procedures become more defined, we expect that audit prices will eventually come down a bit.

Cryptocurrencies present a number of issues for audit firms including: (1) existence of the asset/currency, (2) control of the asset/currency, and (3) custody. For many altcoins, the first two issues can be addressed with a review of the blockchain and the manager showing control of the asset by moving it on the blockchain in some manner. The last issue is potentially more problematic in that the investment management industry is used to a certain definition of custody (holding something) that may not fit within the digital asset space, where control and the ability to utilize an asset is really more of the applicable context.

What about an administrator?

A hedge fund administrator provides certain accounting and other operational functions for the fund like subscription document processing. Normally the fund administrator will be responsible for calculating NAVs on a monthly/quarterly basis and when investors enter and exit the fund. They also compute management and performance fees. Having an administrator is not a regulatory requirement for a cryptocurrency fund, but it is a best practice. We will note that all of the cryptocurrency funds we have worked with have decided to engage an administration firm.

What about bank accounts?

One to two years ago, there was no issue for a manager to get a bank account for a bitcoin hedge fund. Since then, bitcoin has become a risk for banks and over the last six months we’ve seen banks fully eschewing this space. Groups who previously banked bitcoin funds will not bank new funds (although they would continue to maintain existing accounts) and groups who were not in the space are completely staying away. We have fortunately been introduced to a couple of banks who are now more comfortable with banking cryptocurrency clients. While these banks can provide the very basic subscription account for funds, there also may be value-added services, especially with respect to transfers to and from exchanges, as well as API integration.

The process to get a bank account is going to be a little longer than for a traditional hedge fund because the bank will complete more due diligence than for a normal fund (i.e., look into the business background of the manager, the proposed investment program, who the investors are, etc). While these groups are comfortable with the cryptocurrency space in general, they likely will not bank groups who pose even the slightest reputational risk or groups who have had regulatory issues in the past.

What about compliance and outside compliance consultants?

Right now compliance really only applies to the fund structure (as opposed to the manager as would be the case if the manager was an investment adviser). Fund compliance really just involves the legal requirements related to the Regulation D 506 offering applicable to the issuance of fund interests (e.g. Form D filings, annual updates and amendments, blue sky filings, etc).

Compliance related to the management of a cryptocurrency portfolio is really nonexistent. We would expect that the managers would adhere to normal anti-fraud provisions, and a best practice would be to have certain business continuity plans and other standard fund management policies and procedures, even if there is no outside regulatory requirement. Some groups have asked us about setting up compliance programs in anticipation of future compliance needs and we think this is a good idea. Either a law firm or a compliance consulting firm would be able to draft a compliance manual for the needs of a cryptocurrency fund manager.

What about ICOs?

As of right now, there are no extra regulatory requirements around participation in initial coin offerings (ICOs). We believe that this will change in the future.

What are some common terms of bitcoin funds?

The biggest questions are around lock ups and liquidity. In general most managers will tend to want to provide less liquidity than investors are looking for and some managers have thought about instituting gate provisions, especially if the investment program is focused on smaller altcoins that may have less liquidity. We are also seeing a number of managers who would like to allow in-kind contributions and distributions, which will implicate certain tax regulations.

How is bitcoin taxed?

The IRS addressed this issue in 2014 when it released Notice 2014-21, IRS Virtual Currency Guidance. Right now most cryptocurrencies (and other “virtual currencies”) are treated as property and subject to the normal tax principles regarding property. This means that dispositions of virtural currencies will result in short-term or long-term capital gains or losses and not foreign currency gains or losses. Standard ways to determine gain or losses at disposition will apply (for most cryptocurrencies), and we would look to the various exchanges to determine a price of a cryptocurrency at any particular point in time. This would be important if a manager or other investor in a fund decided to invest in a fund through an in-kind cryptocurrency contribution.

According to Notice 2014-21, bitcoin is deemed to be a “convertible” virtual currency because it has an equivalent value in real currency. Early this year bitcoin became legal tender in Japan.

What about separately managed accounts or prop trading?

As of right now we do not know of any way to create a traditional separately managed account structure for an investment in cryptocurrencies. In a SMA structure in the traditional securities space the client will typically establish a brokerage account at a large broker (Schwab, Fidelity, etc) and the manager will be given power of attorney to trade the account. The relationship is governed by some kind of advisory agreement laying out the fees and term of the relationship. Typically the brokers will have a way for the manager to have trading only access to the client’s account. We do not believe that any of the exchanges currently have this functionality. We anticipate that sometime after the regulatory agencies implement a regulatory structure that the exchanges will create mechanisms to implement such relationships on their platforms.

Other Items

We anticipate writing about the following soon in some fashion:

Creating structures to allow funds to invest on exchanges that do not allow U.S. persons

Creating structures to allow funds to invest on exchanges that do not allow New York persons

Third party marketing in the cryptocurrency space

Using the ICO process to launch a private fund

Issues around Regulation D, including the Bad Actor regulations

Final Notes

Please reach out if you have questions on any of the above. We will continue to update as we run into more issues and common questions.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

As cryptocurrencies continue to make headlines, questions continue to arise about the regulatory landscape applicable to market participants. While there have been no new laws or regulations related to the cryptocurrency space from federal agencies (although in the Coinflip order, the CFTC stated that bitcoin is a virtual currency), some states are beginning to examine cryptocurrencies with New York as a forerunner in this space. In 2015, New York created a BitLicense Regulatory Framework whereby certain cryptocurrency market participants were required to obtain a license to transact business within New York (and/or with New York residents). This post focuses on New York’s regulatory action regarding cryptocurrencies with the issuance of the BitLicense, and the potential impact this may have on investment managers.

New York BitLicense

Pursuant to the Part 200. Virtual Currencies regulations, any persons involved in “virtual currency business activity” in New York must obtain a license known as the “BitLicense.” The regulation defines a “virtual currency business activity” as:

receiving virtual currency for transmission or transmitting virtual currency, except where the transaction is undertaken for non-financial purposes and does not involve the transfer of more than a nominal amount of virtual currency;

storing, holding, or maintaining custody or control of virtual currency on behalf of others;

buying and selling virtual currency as a customer business;

performing exchange services as a customer business; and

controlling, administering, or issuing a virtual currency.

The above categories really seem to apply to those groups who are acting as cryptocurrency exchanges and/or are offering “wallet” type services. For most fund managers who are simply managing a fund which is investing in virtual currencies, the above items would not implicate such managers and such managers would not need to obtain the BitLicense. However, if a manager (or an investment fund) was engaged in activity other than simply buying/selling/holding cryptocurrencies, the manager should be aware of the above items.

BitLicense Application

In order to receive the license, an applicant must complete a 30-page Application for License to Engage In Virtual Currency Business Activity and pay a $5,000 application fee. The application requires information on the history of the business, its owners and operators, operational items, financials, information on AML procedures, and information on its general compliance processes. In total the application is fairly onerous and costly and will likely deter many potential companies for applying for the license. Few BitLicenses have actually been granted to date, and those that have been granted were to major players in the industry such as Coinbase and Ripple.

Other Related Items

There are a number of interesting related items and a discussion about these can be found on the BitLicense FAQs page. A couple of the more interesting items:

Chartered New York Bank – if a group is already chartered under the New York Banking Law, that entity does not need to apply for the BitLicense but must first receive prior approval from the New York Department of Financial Services to engage in the activity.

Money Transmitter License – groups who engage in certain activities may also need to apply for a money transmitter license in New York. Groups who are applying to engage in both activities only need to submit one application.

The two items above are most likely not applicable to fund managers.

Looking Forward

The establishment of a BitLicense demonstrates that states are trying to figure out how to assert authority over a space that prides itself on decentralization. The New York BitLicense has been seen as controversial, along with similarly proposed licenses in other states. Although this appears to not have a direct impact on investment managers yet, investment managers that engage in certain kinds of virtual currency activity may fall within the scope of requiring a license.

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Cole-Frieman & Mallon LLP 2017 1st Quarter Update – we were a little late for this first quarter but the update addresses a number of items including:

Trump and Dodd-Frank Reform

DOL Fiduciary Rule Delay

Bitcoin Regulatory Matters

California’s Public Investment Fund Disclosure Requirements

SEC No-Action Letter and Guidance Clarify Inadvertent Custody

SEC / FINRA 2017 Exam Priorities

Compliance Calendar

Trump Tax Plan & Financial Industry – while our quarterly update talked in part about potential future reform of the financial system, there is not really much to say yet about Trump’s one page tax plan. We do know, obviously, that the details will be forthcoming, but this plan leaves a lot of open questions and (surprise) remains silent on the carried interest issue. One item to note is that the tax plan proposes to repeal the 3.8% Obamacare tax – this is important because many fund managers have established structures to minimize the impact of this tax to the manager. As more information rolls out, we expect to hear from both accountants and tax planners about how any new tax plan would affect the private funds industry.

Blockchain / Cryptocurrency / Altcoin Items – there continues to be an onslaught of items dealing with blockchain technology in the financial services sector, and we included some discussion of these items in our quarterly update linked above. On Wednesday of this week I attended EY’s Global Blockchain Summit in San Francisco (more on this coming soon). In addition, FINRA just announced a Blockchain Symposium which will be held in New York on July 13. According to the announcement, the “half-day program is designed to bring together regulators and industry leaders to discuss the use of blockchain and related opportunities and challenges.” It is important to note that blockchain appears to be an inevitable new structure/paradigm in business generally and investment management specifically – surprisingly, the regulators seem to be aware of this sea change and ready to work with the industry to implement appropriate regulatory structures to address investor protection concerns.

Other Items

Connecticut Hedge Fund Tax – there have been a few news articles about a potential tax on private fund managers in Connecticut. I have not kept up on this issue in depth, but it should be interesting to see how this plays out and whether any other states will follow suit.

FINRA Insider Trading Information – FINRA has begun to take an active role in finding and dealing with insider trading. Just recently they released an interesting video with Cam Funkhouser, Executive Vice President of FINRA’s Office of Fraud Detection and Market Intelligence (OFDMI), about insider trading and some “red flags” to look out for.

Below is our quarterly update which went out via email today to our firm’s clients and friends. Links coming soon.

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April 27, 2017

Clients, Friends, Associates:

We hope that you are enjoying an auspicious start to 2017. The first quarter of the year is typically one of the busiest for fund managers from a regulatory standpoint. As a variety of filing deadlines have passed and audit work is completed (or will be soon), we enter the second quarter with a number of important regulatory issues on the horizon, as well as many other topics worthy of discussion. Below, we have prepared a short overview of some of these items.

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Regulations and Proposed Regulations:

Trump Executive Order Could Reform Dodd-Frank. President Trump issued an executive order on February 3, 2017, setting out seven “Core Principles” which will serve as general guidelines for financial regulatory reform. The Core Principles include making regulation more efficient, effective and appropriately tailored, as well as rationalizing the Federal financial regulatory framework. The order appears implicitly targeted at reforming the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and decreasing many of the current financial regulations, but we note that any changes to the current regulatory landscape may not be as immediate as many initial reactions assumed. According to the order, the Treasury Secretary is to meet with the various agencies that oversee and implement Dodd-Frank (including the SEC), to discuss areas that may be amended. While a repeal of Dodd-Frank is unlikely, the coming months may bring a number of deregulatory changes. We will be following any resulting changes and will discuss significant impacts of such changes in future quarterly updates.

Department of Labor Delays Fiduciary Rule. On April 7, 2017, in response to a presidential memo from President Trump, the Department of Labor (“DOL”) issued a Final Rule delaying the applicability of the “Fiduciary Rule” until June 9, 2017, although full compliance with the Fiduciary Rule is still expected by January 1, 2018. We had previously discussed the Fiduciary Rule, which expanded the scope of who is considered a “fiduciary”, imposing fiduciary obligations on firms which were historically free from such obligations. While the DOL will use the delay to reexamine the Fiduciary Rule and consider modifications to it, if you have not already done so, we recommend that you review and speak with your counsel about whether you would be considered a fiduciary and what additional obligations and implementation processes will need to be incorporated into your business practices.

CFTC Regulation of Bitcoin and Virtual Currencies. There has been an increasing interest in investments in Bitcoin and other cryptocurrencies as the financial and technological landscape evolves, but determining the regulations applicable to such products is less clear. While the CFTC established that Bitcoin and other virtual currencies are “commodities” within the definition of the Commodity Exchange Act of 1936, as amended (“CEA”), under the CEA, only commodity interests (which include futures, options, derivatives and certain spot transactions) based on the commodity are within the scope of the CFTC’s jurisdiction. Recent enforcement actions brought by the CFTC have helped clarify whether a transaction is subject to CFTC regulation. In an Order issued against the Coinflip, Inc. platform (“Coinflip”), the CFTC imposed sanctions against Coinflip for operating a facility for trading Bitcoin derivatives without being registered as a futures exchange or swap execution facility. In a contrasting enforcement action brought against the Bitfinex platform (“Bitfinex”), which did not list or permit the trading of derivatives, the CFTC asserted its jurisdiction over Bitfinex on the basis that the platform dealt in “retail commodity transactions”— leveraged, margined or financed transactions involving a commodity that are offered to persons that are not “eligible contract participants” — without being registered as a futures commission merchant with the CFTC. Certain retail commodity transactions are exempt from CFTC jurisdiction if the seller “actually delivers” the commodity to the buyer within 28 days of the date the contract was entered into; the CFTC deemed that Bitfinex did not “actually deliver” the cryptocurrencies to buyers because among other reasons, Bitfinex held the private key controlling access to the wallet where the buyers’ cryptocurrencies were held.

Managers investing in Bitcoin or other virtual currencies should consider whether and to what extent the types of transactions may subject them to CFTC jurisdiction and potential registration as a CPO or CTA. In the current regulatory landscape, we believe managers who invest purely in virtual currencies and who do not employ virtual currency derivatives or leverage are outside the scope of the CFTC’s jurisdiction, and should not be required to register as a CPO or CTA. Although further regulation is expected, firms should speak with outside counsel to confirm their status in light of the current regulatory framework.

Other Regulation of Bitcoin and Virtual Currencies. While the CFTC has been the most active regulatory authority to address investments in cryptocurrencies, managers should be cognizant that states (including New York), the SEC, FINRA and FinCEN are also deliberating the question of appropriate regulatory oversight. We will continue to monitor regulatory developments and more information about certain regulatory aspects applicable to private funds can be found in our blog post on Bitcoin / Cryptocurrency Hedge Funds.

NFA Provides Guidance on Amended CPO Financial Report Requirements. In our previous 2016 End of Year Update we discussed the CFTC’s amendments providing relief from certain financial report requirements for commodity pool operators (“CPOs”), which became effective on December 27, 2016. The NFA released a Notice setting forth instructions regarding how CPOs can file the appropriate notices with the NFA to claim any of the relief provided for in the amendments. CPOs who are eligible for the amended regulations should contact counsel or compliance consultants, or review the Notice, to determine whether any further action may be warranted to claim the appropriate relief.

U.S. and Global Regulators Relax March 1st Deadline for Swap Variation Margin Compliance. The Federal Reserve and the International Organization of the Securities Commission have provided some flexibility for swap dealers facing a March 1, 2017, deadline to implement certain variation margin compliance requirements for uncleared swaps. The rules require swap dealers to collect and post variation margin with no credit threshold unless an exception applies. Further, covered counterparties would be required to enter into new or amended credit support documentation, limit the types of collateral that may be posted and prescribe minimum transfer amounts. Compliance with the requirements can be challenging for swap entities and their counterparties as they work to implement the necessary documentation and underlying operational processes. Except for transactions with financial end users that present “significant exposures,” the Federal Reserve’s guidance directs examiners of CFTC-registered swap dealers to focus on the dealer’s good faith efforts to comply as soon as possible but by no later than September 1, 2017.

BEA Makes Changes to Direct Investment Survey Reporting Requirements for Certain Private Funds. The Bureau of Economic Analysis’ (“BEA”) changes to its direct investment surveys went into effect on January 1, 2017. The reporting changes apply to investments by U.S. entities of a 10% or more voting interest in a private fund, and to investments by foreign entities of a 10% or more voting interest in a U.S. domiciled fund. Under these changes, any cross-border voting investments of 10% or more in, or by, private funds will be subject to BEA reporting only if such investments involve, directly or indirectly, a direct investment in an “operating company” that is not another private fund or a holding company. The changes will simplify reporting for private funds because certain direct investments in private funds will be re-characterized as portfolio investments depending on the nature of the private fund’s investments. Many hedge funds that were traditionally subject to BEA direct investment reporting because of cross-border voting interests will instead only be required to report on portfolio investments to the Treasury Department on Treasury International Capital (“TIC”) surveys. The BEA will notify any filers that may be potentially affected by these changes, but we recommend that advisers consult with counsel to determine what, if any, BEA and/or TIC reporting obligations they may have.

Treasury Department Proposes New Anti-Money Laundering Rules for Investment Advisers. The Treasury Department’s Financial Crimes Enforcement Network previously proposed extending the requirements of maintaining a formal anti-money-laundering (“AML”) program under the Bank Secrecy Act of 1970 to SEC-registered investment advisers (“RIAs”). The final rule is expected to be published soon, and would require SEC RIAs to establish a robust AML program with policies and procedures to identify questionable activity, periodic testing of the program and ongoing training of appropriate personnel.

Other Items:

California’s Public Investment Fund Disclosure Requirements Now Effective. In our third quarter update, we reported that California passed a bill requiring increased disclosure by private fund managers for funds with investments by California state and local public pension and retirement systems. The legislation went into effect on January 1, 2017. All public pension and retirement systems in California must require hedge funds, private equity funds, venture capital funds and any other alternative investment vehicles in which they invest to disclose certain information regarding the fund’s fees, expenses and performance. In addition to applying to new contracts entered into on or after January 1, 2017, and pre-existing contracts with new capital commitments made on or after January 1, 2017, the legislation requires that public pension and retirement systems make “reasonable” efforts to obtain the increased disclosure information for contracts entered into prior to January 1, 2017. Fund managers with California public plan investors should review the types of information that will need to be provided to such investors and prepare to provide the required information.

SEC No-Action Letter and Guidance Clarify Inadvertent Custody. On February 21, 2017, the SEC issued a no-action letter responding to a request for clarification from the Investment Advisers Association as to whether an investment adviser has custody of a client’s assets if the adviser acts pursuant to a standing letter of instruction or other similar arrangement established between the client and its custodian (“SLOA”), that grants the adviser limited authority to direct transfers of the client’s funds to one or more third parties. The SEC’s position is that an SLOA that authorizes the adviser to determine the amount and timing of payments, but not the payee’s identity, is sufficient authority to result in the adviser having custody of the assets. However, the SEC agreed that it would not recommend an enforcement action against an adviser that does not obtain a surprise examination, if the adviser acts pursuant to an SLOA under certain specific circumstances set forth in the SEC’s letter. The SEC also reaffirmed that advisers will not be deemed to have custody of client assets if the adviser is given limited authority to transfer client assets between the client’s accounts maintained at one or more custodians.

To further clarify its views on inadvertent custody, the SEC also issued a guidance update highlighting certain circumstances where an investment adviser may inadvertently have custody of client funds or securities. An adviser may have custody because of the wording or rights of custodial and advisory agreements, even if the adviser did not intend to have custody and was not aware it was granted the authority that resulted in its having custody. We urge advisers to separately managed accounts to review their client agreements and any SLOAs they have entered into to determine whether their specific arrangements may cause them to have custody, and to evaluate their policies and practices related to custody of client assets.

SEC Published Examination Priorities for 2017. The SEC announced its Examination Priorities for 2017, which focus on themes of examining matters of importance to retail investors, focusing on risks specific to elderly and retiring investors and assessing market-wide risks. Specifically, the SEC will focus on: (i) identifying initiatives designed to assess risk in the context of retail investors, including never-examined investment advisers and exchange-traded funds, and notably, robo-advisers and other automated, electronic investment advice platforms, including the investment advisers and broker-dealers that offer them; (ii) services provided to retirement accounts, such as variable insurance products and fixed-income cross-transactions, as well as investment advisers to pension plans and other large holders of U.S. investor retirement assets; and (iii) cybersecurity, and systems and technology procedures and controls.

FINRA Published Examination Priorities for 2017. Similar to the SEC, the Financial Industry Regulatory Authority, Inc. (“FINRA”) recently published its 2017 Regulatory and Examination Priorities Letter, outlining the organization’s enforcement priorities for the current year. FINRA’s specific focus areas for 2017 will include: (i) supervisory policies and compliance controls for high-risk and recidivist brokers; (ii) sales practices and product suitability for specific investors; (iii) firm liquidity management practices; and (iv) cybersecurity issues. We recommend that you speak with your firm’s outside counsel and service providers to learn more about these specific priorities and review your firm’s compliance with the applicable regulations.

Cayman Islands Extends CRS First Notification and Reporting Deadlines. The Cayman Islands Department for International Tax Cooperation (“DITC”) has issued an industry advisory stating that it is adopting a “soft opening” to the notification and return deadlines required for Financial Institutions’ (“FIs”) compliance with the Common Reporting Standard (“CRS”). All FIs in the Cayman Islands are required to register with the Cayman Islands Tax Information Authority (“TIA”) by April 30, 2017, and to submit returns to the TIA by May 31, 2017. With the DTIC’s adoption of a “soft opening,” FIs may submit CRS notifications on or before June 30, 2017, and file “accepted” CRS returns on or before July 31, 2017, without any compliance measures or penalties.

Ninth Circuit Rules Internal Reports Protected under Whistleblower Rules. On March 8, 2017, the Ninth Circuit followed a ruling by the Second Circuit in finding that an employee who makes a report internally, rather than to the SEC, is protected under Rule 21F-17 of the Securities Exchange Act of 1934, as amended (“Whistleblower Rule”) enacted under Dodd-Frank. In contrast, the Fifth Circuit previously ruled that the provisions of the Whistleblower Rule only apply when an employee makes disclosures directly to the SEC. The Ninth Circuit and Second Circuit rulings reflect a broad interpretation of the definition of a whistleblower, and signal a split among the circuit courts on who may be considered a whistleblower for purposes of protection under the Whistleblower Rule.

Regulatory Assets Under Management. We have observed that many managers have expressed confusion regarding the calculation of assets under management (“AUM”) for purposes of filing the Form ADV and determining when the manager may be subject to SEC registration. We thought it would be helpful to clarify that investment advisers must look to their “regulatory assets under management” (“RAUM”), a specific metric designed by the SEC, which is calculated differently from the more common and more traditionally understood calculation of AUM. In calculating RAUM, managers should include the value of all assets managed without deducting for any offsetting liabilities. Managers with questions about the calculation of specific assets or managers seeking further clarification of RAUM should speak with their firm’s outside counsel or compliance consultants.

Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

May 31, 2017 – First deadline for Cayman Islands Financial Institutions to submit their CRS returns to the Cayman Islands Tax Authority

May 31, 2017 – Third reporting deadline (full reporting) for Cayman Islands Financial Institutions with reporting obligations under the Cayman FATCA regulatory framework to report their U.S. Reportable Accounts to the Cayman Islands Tax Authority

June 30, 2017 – Distribute audited financial statements to investors (private fund managers to funds of funds, including SEC, state and CFTC registrants)

Variable

Distribute copies of K-1 to fund investors

Ongoing All Limited Non-U.S. Financial Institutions and limited branches that seek to continue such status during the 2017 calendar year must edit and resubmit their registrations after December 31, 2015, on the FATCA registration website; SEC form D must be filed within 15 days of first sale of securities

Please contact us with any questions or for assistance with any compliance, registration or planning issues on any of the above topics.